AN EVALUATION OF CAPITAL STRUCTURE AND PROFITABILITY OF BUSINESS ORGANISATIONS

Introduction

1.1 Background To The Study

Whether a business is newly born or it is an ongoing, it requires fund to carry out its activities as no success is achievable in the absence of fund. The needed fund may be for daily running or business expansions. This tells us how important or essential fund is in the business, this fund is referred to as capital .it is therefore a symbol of a company’s financial liabilities.

This study focuses on the association between capital structure & profitability of some manufacturing firms listed quoted in Nigeria. Capital structure is one of the most puzzling issues in corporate finance literature (Brounen & Eichholtz, 2001). The concept is generally described as the combination of debt & equity that make the total capital of firms. The proportion of debt to equity is a strategic choice of corporate managers. Capital structure decision is the vital one since the profitability of an enterprise is directly affected by such decision. Hence, proper care and attention need to be given while determining capital structure decision.

Capital structure is the proportion or each type of capital debt and equity used by a business organization. Many organizations employ debt in their capital structure because of its benefits. One of the benefits is that interest on debt is tax deductible and reduces tax liability of the organizations concerned. Furthermore, failure to pay interest commitment can result to financial backwardness. The financial managers consider so many factors in their capital structure decisions because of the implications in the use of debt. The factors are cost of capital, debt capacity cash flow. Etc. In the statement of affairs of an enterprise, the overall position of the enterprise regarding all kinds of assets, liabilities are shown.

Capital is a vital part of that statement. The term “capital structure” of an enterprise is actually a combination of equity shares, preference shares and long-term debts. A cautious attention has to be paid as far as the optimum capital structure is concerned. With unplanned capital structure, companies may fail to economize the use of their funds. Consequently, it is being increasingly realized that a company should plan its capital structure to maximize the use of funds and to be able to adapt more easily to the changing conditions (Pandey, 2009). The relationship between capital structure and profitability is one that received considerable attention in the finance literature.

Capital structure is important to understanding how a business is run and financed, and can be easily evaluated by looking through a corporate balance sheet. Capital structure refers to the relationship between a company’s assets and liabilities, including how the assets are funded and the amount of debt managed by the firm. The capital structure decision is crucial for business organizations. The capital structure decision is important because of the need to maximize returns of the firms, and because of the impact, such a decision has on the firm’s ability to deal with its competitive environment. The capital structure of a firm is a mixture of different securities. In general, firms can choose among many alternative capital structures. For examples, firms can arrange lease financing, use warrants, issue convertibles bonds, sign forward contracts or trade bond swaps. Firms can also issue dozens of distinct securities in countless combinations to maximize overall market value (Abhor, 2005, p.438).

A number of theories have been advanced in explaining the capital structures of a firm. Despite theoretical appeal of capital structure, researchers in financial management have not been able to find a model for an optimal capital structure. The best that academics and practitioners have been able to achieve are prescriptions that short –term goals (Abor, 2005, p.438).

Profitability and capital structure relationship is a two way relationship. On the one hand profitability of firm is an important determinant of the capital structure, the other hand changes in capital structure affect underlying profits and risk of the firm that is reflected in the value of the firm.

The most important decision all corporate managers should take into consideration is the way in which the long-term capital requirements of their companies should be financial. Capital structure is the permanent financing of a firm represented primarily by equity and long-term liability without including all short-term credits. Many factors have to surface in order to determine the capital structure of a business organization.

These factors are what the financial managers consider first in order to determine appropriate capital structure suitable to his firm. Some of the factors are: cost of capital, floatation costs, and size of the company, government policies and market condition. The combination of debt and equity has some implication. The first is that debt-equity ratio, which is regarded as an indicator of risk.

The profitability of any business organization will determine whether it will remain in business or not especially in the long run. Profitability is normally measured using return on capital employed, return on equity, earning per share, and return on assets, net profit margin and gross profit margin.

Capital structure has been a major issue in financial economics ever since Modigliani and Miller showed in 1958 that given frictionless markets, homogeneous expectations; capital structure decision of the firm is irrelevant. By relaxing the assumptions and analyzing their effects, theories seek to determine whether an optimal capital structure exists or not, and if so what could possibly be its determinants. The relationship between capital structure decisions and firm value has been extensively investigated in the past few decades. Capital structure could have two effects; according to Desai (2007) firms of the same risk class could possibly have higher cost of capital with higher leverage. Second, capital structure may affect the valuation of the firm, with more leveraged firms, being riskier and consequently valued lower than the less leveraged firms. If the manager of a firm has the shareholders’ wealth maximization as his objective, then capital structure is an important decision, for it could lead to an optimal financing mix which maximizes the market price per share of the firm.

Nigeria is a developing country with a single stock exchange (Nigerian Stock Exchange NSE) but with few branches across the country, accommodate about 260 securities. Like other developing economies, the area of capital structure is relatively unexplored in Nigeria. Limited research work exists on this area, like salawu (2007) studied empirical analysis of determinant of capital structure of 50 selected non-financial companies between 1999 and 2004. This study built on that of Salawu (2007) by adding to exogenous variables, using a wider time frame and considering the impact of the previous year’s leverage on the current year ones. (CBN report 2009)

1.2 Research Problem

The owners of a company will not like to lose the control they have in their company by issuing more shares to the public in order to finance their capital projects. Instead, they do borrowing, this means using debt instrument like debenture stock. These owners of the business should not fail to know that whether there is profit or not that the debentures should be settle their interest. Nobody can perfectly predict the future, there can be business boom and there can equally be stump in business. The problem then is how can business combine debt and equity financing in order to ensure profitability?

The emergent nature of the Nigerian capital market with its inherent problems of inactive debt market, shallow nature of the market, buy and hold syndrome of Nigerian investors and so on, coupled with the unconducive socio-political environment make firms in Nigeria to rely more on the money market than the capital market for their funds requirement. Hence the money market is dominant in the Nigerian financial system.

The difficulty facing firms in Nigeria has to do more with the financing – whether to raise debt or equity capital. The issue of finance is so important that it has been identified as an immediate reason for business failing to start in the first place or to progress (Graham, 1996). Thus, it is necessary for firms in Nigeria to be able to finance their activities and grow over time, if they are ever to play an increasing and predominant role in creating value added, as well as income in terms of profits.

The multiplier effects of this aberration put a question mark on the true relationship between capital structure and profitability of quoted manufacturing firms in Nigeria. That is, whether trade – off theory which supports a positive relationship or pecking order theory which supports a negative relationship. The study seeks to examine this relationship.

1.3 Purpose Of The Study

The present study is aimed at achieving some objectives. The main objective of this research work is as follows:

1. To determine the relationship between capital structure and profitability of listed firms in Nigeria.

1.4 Research Question

The objectives are translated in this research question and will be answered based on the empirical evidence generated.

The following is the main research question guided in this study:

1. To what extent does capital structure influence profitability of listed quoted manufacturing companies in Nigeria?

1.5 Statement Of Hypothesis

The following hypotheses have been formulated to guide this study.

Ho: There is no significant relationship between capital structure and profitability of manufacturing firms in Nigeria.

1.6 Scope And Limitations Of The Study

Not minding that capital structure has many implications on a company such as profitability, market value of shares and financial distress, this study took at the relationship between capital structure and profitability of business organization. Business organization studied was some listed quoted manufacturing companies in Nigerian.

This research is limited to ten quoted manufacturing companies in Nigeria; some of the other quoted listed firms researched on do not have complete data of relevant variable due to cessation of operation or problems with Nigerian Stock of Exchange (NSE) and Securities Exchange Commission (SEC). The study excludes financial, utility and other highly regulated industry to avoid any distortions in the result due to industry specific requirements.

1.7 Significance Of The Study

Business financing is a very important business decision. Corporate financial managers have to decide whether to employ more of debt or more of equity whichever measure is adopted has effects. Everybody should bear in mind that the main objective of every business is to make profit of which this research work will through its findings achieve the followings:

1. To convince corporate managers of the relationship between capital structure and profitability of business organization and will enable them make appropriate decision to that effect.
2. It will help intending investors to plan their capital structure very well from the statement in order to maximize profit.

Profitability is regarded as a major determinant of capital structure, a part that bankruptcy costs, agency costs, taxes, and information asymmetry etc. are considered in determination of capital structure.

The topic of capital structure has been widely explored, though the study is relevant in the different time period and different context to find out whether the evidence concerning the capital structure issue and its various aspects are relevant to a given set of companies in a given period. Given this significance, current study attempts to understand and research on capital structure and its effect on profitability, an important relationship that is not given much attention before, of large firms in Nigerian in the present context.

This will be of good advantage to future researchers in their research work.

1.8 Definition Of Terms

Capital Structure:

Capital structure as an avenue through which an organization provides funds to its general operations by using altered sources of money. It involves the mixture of equity and debt.

Profitability:

It is the measurement of overall earning capacity of a firm .Profitability is the primary target of a firm to achieve in long run for the development of its organization over the years.

Long term assets:

The worth of a company’s possessions, tools and other capital resources. These are informed on the left side of the balance sheet. Assets that are not in intention to be twisted into cash or be devoted within one year of the balance sheet date.

Short term assets:

These are assets held with a company within a year or lass then one year. It includes account receivable, cash at bank, cash in hand etc. Current assets show the liquidity of an organization. These assets are consumed within a year or in the operating cycle without upsetting the regular process of an organization.

Long term liabilities:

A long- term liability is one the company imagines to pay over the course of more than one year.

Short term liabilities:

Is one the company supposed to pay in the short term with in the period of one year or less than one year using assets prominent on the present balance sheet. The obligations that will settle by short term assets are known as short term liability.

Return on equity:

Is the amount of money that is returned to the shareholders from their equity and it computes the prosperity of owner’s assets. Return on equity assess an organization’s profitability by informative how much profit a company produce with the money shareholders have invested.

Financial Leverage:

This is the use of fixed charges source of fund such as debt and preference capital along with the owner’s equity in the capital structure.

Debt:

Debt is loan borrowed from outsider to finance a business. It is repayable and receives a return in form of interest charged on the amount of debt outstanding.

Equity:

It is a permanent investment in a company. Equity investment makes a person a part owner of the company. This is also a method of long-term financing. It includes share capital, share premium and reserves.

Listed Quoted Companies:

Is a company whose shares can be bought or sold on the stock exchange, it also a company issuing the security must meet the requirement s of the exchanges it wishes to be traded.